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Monetary Policy: role of interest rates

As in life, an economy undergoes phases – good and bad. The challenge lies with the government and the central bank to firstly prevent the economy into going into bad phases – as much as they can, and if it does enter a bad phase, to pull it out of it and make it enter a better phase. But things are not black and white. Sometimes features of a good phase may in fact attract some unwanted results, and if attention is not paid in time, can prove really harmful in the long run.

The biggest goal for any economy is high growth. At the end of the day, you want your economy to grow as high growth means more things (goods and services) are being produced and consumed and people are getting higher incomes. But remember an economy never runs on a straight path, but always in cycles. This high growth and resultant high incomes can also lead to high prices. How?

Simple demand and supply economics says that if the supply remains the same, and demand goes high, prices will rise. This is exactly what will happen in a high growing economy. If people are earning more income, it is natural that they will demand more goods and services as they would now like to spend that higher amount of money that they have in their hands. What this will do is drive prices up – something the economists refer to as inflation. Thus, something good (high growth) can lead to something bad(inflation). Cycles you see! What the above example also shows is that growth can be increased if you put money in people’s hands as that will increase the demand for goods and services –something which can be done in times of low growth.

What that means is that in a period of high growth you have to be careful of rising prices and take remedial measures. And in a period of low growth, you obviously have to take

measures to attain your primary goal – growth. So what measures are these? The government can achieve results it wants to by changing a key variable – money in people’s hands or money that is circulating in the economy or what is technically called as LIQUIDITY. Bringing changes to liquidity can do a lot. There are two policy measures that affect illiquidity – Fiscal Policy and Monetary Policy.

At a broad level, fiscal policy (adopted by the government) is policy that deals with taxes and expenditure of the government. What government takes form people (tax) and what it spends in the economy (expenditure). Any changes brought to these two are measures of fiscal policy. Like we have changes in tax rates in budgets shown on TV. That’s fiscal policy right there!

Monetary Policy (adopted by the central bank) is regulating liquidity in the economy by regulation of interest rates and other variables.

We have already seen what excess amount of money in people’s hands can do – drive up prices. And deficient amount can lower growth rates. Thus, at any point of time – the right amount of money should be with people. Not too less, not too much.

That’s the central bank’s job. Regulation of this money. Like a fan regulator regulates the speed at which the fan works. If there is too much heat, it will increase the speed, if there is too much cold, it will increase the speed. The same job is done by the Central bank. If the economy is overheating (high growth, high prices), it will decrease the liquidity (money circulating in the economy), if the economy is too cold for comfort(low growth, low prices), it will increase the liquidity.

But how does the Central Bank (Reserve Bank of India or RBI in case of India) do it? Quite simple. If you want to increase or decrease the amount of money people will have in their hands – change its cost. Change how costly it is to get money. Hang on. Cost of money? What is that?

This is what it is. Interest rate. How? Lets see.

In an economy there are two kinds of people – those with excess money (with more money than they need) and those with deficient money (with less money than they need). Typically, they do a deal. The lucky ones with more money lend it to those who need it. But nothing comes for free. With time and rising prices, value of money will decrease. What Rs 100 bought you yesterday, it will get you a lesser amount today, because the prices have risen. So If I give you money today and you return the exact same amount after an year, I am at a loss, because the value of that amount has dropped. IT will buy me lesser amount of things today. So what happens – the borrower returns the money he borrowed (i.e. the principle) and also pays an interest (according to the interest rate).

If A lends to B Rs 100 at a rate of interest of 10% per annum, after an year if B returns Rs 100, A will be at a loss but according to the interest rate, if he returns Rs 110, A is in a good position, especially if inflation is below 10. This is because it is inflation i.e. rise in prices that reduces the value of money. So if the inflation is 6% and interest rate A gets is 10%, A stands to gain 4%.

That is how the interest rate is the cost of money. It is a spending for the borrower and earning for the lender. Now lets see things in a bigger picture by looking at the chain of the monetary system.

In an economy, the central bank prints the money lends it to the commercial banks who further lend it to the general public – both producers and consumers. But again all of these entities do not deal in money for free – they do it in terms of the interest rate. The RBI gives money to the banks at a certain rate of interest, say x% (cost of borrowing for bank). The banks, looking to earn a profit, gives the money to the consumers (or producers) at x+y% earning a profit of y%. e.g. if banks get money at 5% from the central bank and lend to consumer at 7%, they earn 2% margin. Now what if the central bank raises this rate from 5% to 6%, the bank who will want to maintain the 2% margin, will now charge 8% to the consumer whose cost of borrowing will increase, and guess what he will do? Take less money from bank. Opposite will happen if rate decreases from 5 o 4% and bank reduce their rate from 7 to 6%. Consumers will see it as an opportunity as their cost of borrowing decrease and they will demand more money.

Thus, with a stroke, the central bank can change the liquidity i.e. the amount of money circulating in the economy. And its simple, in times of rising prices, central bank will increase interest rate to decrease demand. And in times of low growth, it will decrease interest rate to increase demand.

Apart from interest rate, there are other tools of monetary policy such as open market operations (buying and selling of securities by the government) and reserve requirements (changing the amount of money banks have to keep as a reserve). Further, there are different kinds of interest rates like repo rates, reverse repo rates etc. More on that in another article.